Early Withdrawal From 401(k) Due to Work Termination

An early 401(k) distribution can cost you on your taxes.

An early 401(k) distribution can cost you on your taxes.

One of the many things you’ll need to think about if you quit your job or are laid off is what you’re going to do with your employer-sponsored 401(k) plan. You have several options to choose from, including cashing out your 401(k) after leaving the job. Unfortunately, requesting a lump sum distribution means you’ll have to pay income tax on any previously untaxed part of the money you withdraw. If you’re younger than age 59 ½, the distribution will be seen as an early withdrawal by the IRS, which could mean an additional 10-percent tax penalty. Rolling over the balance or leaving it in place may be better choices if you don’t want to give up a large portion of your 401(k) for taxes.

401(k) Payout After Termination

Your ex-employer may require you to take a 401(k) payout after termination, especially if the balance in your account is less than $5,000. Even if you’re allowed to keep your money in the plan, you may decide you’d rather not have anything else to do with your former employer. However, taking a significant distribution could put you into a higher tax bracket and require you to pay 20 percent or more of the distribution in taxes. If you want to take a 401(k) distribution after termination of employment but don’t want to pay more taxes, you can roll the money over to a qualified plan without penalty, provided you follow IRS guidelines. Some plans require you to provide written permission from your spouse before withdrawing money from the account.

Rolling Over a 401(k)

Rolling over a 401(k) means you are withdrawing some or all of the balance and placing it in a non-taxable investment account, such as another 401(k) or an Individual Retirement Account or IRA. An IRA rollover is a good choice because most IRAs have more investment options than 401(k)s, and will allow you to diversify your investments. If you move from one job to another, you also have the option of rolling over your old 401(k) into your new employer’s plan. Before you decide to do this, compare investment returns and fees for the two plans. A rollover is usually initiated by contacting your 401(k) plan administrator or by requesting a withdrawal and moving the money yourself. As long as you complete the rollover of a 401(k) withdrawal within 60 days, you will not be taxed or penalized.

Keeping 401(k) With Old Employer

If your former employer allows you to keep your 401(k) account following termination, weigh the pros and cons of keeping your money where it is. Since the goal of a 401(k) account is saving for retirement, your money may grow faster in your current account if the plan’s investments have been good in the past. You won’t be able to add to the account with deposits, but the money will have a chance to grow for retirement if you leave it alone. Another reason to hold onto the 401(k) is if the fees are lower than what you would pay if you roll the money over into an IRA. You still have the option of withdrawing money from the 401(k) at a later date.

Exception to Early Withdrawal Rule

For 401(k) account holders who lose their jobs, there is an important exception to the IRS early withdrawal penalty. If you lose your job when you are age 55 or older, you can take a 401(k) payout without incurring an early withdrawal tax penalty. This exception is often referred to as the “age 55 rule.” It helps protect those who lose their jobs when they are close to retirement age and need to tap into their retirement savings.

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About the Author

Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.

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